Contractors’ Claims Insurance: A Risk Retention Approach
Publication: Journal of Construction Engineering and Management
Volume 135, Issue 9
Abstract
The negative effects of claims and disputes have serious negative impacts on contracting parties, their projects, the construction industry as a whole, and consequently on the nation’s economy. This paper explores a method for mitigating the negative effects associated with contractors’ claims and disputes using a risk retention approach. This method can help contractors in getting early relief from the financial and economic burdens of construction claims. To meet the goals and objectives of this study, the writers have: (1) investigated the feasibility of pricing insurance premiums using the options pricing theory; (2) explored the applicability of modeling the options pricing theory using Monte Carlo simulation; (3) set up the principles required for optimal design of a risk retention group for construction claims; and (4) tested the possible impact of the newly developed risk retention group using historic data of 10,193 construction projects spanning over 12 different California districts. Pursuant to this study, it was verified that construction claims satisfy the required principles for insurance. Also, based on the used testing framework, the developed risk retention group for construction claims has been proved a success from the insured and insurer sides. It is the writers’ hope that this study will lay the basis for a leading risk management technique that could be extended over the nation for the benefit of relieving the negative consequences associated with lengthy claims and disputes resolution in the construction industry.
Get full access to this article
View all available purchase options and get full access to this article.
Acknowledgments
This work would have never been completed without the sincere and genuine guidance provided by Dr. Dermot Hayes, Pioneer Chair, Professor of Economics, and Professor of Finance at Iowa State University as well as by Dr. Mark Power, University Professor, Principal Financial Group Finance Fellow, and Professor of Finance at Iowa State University. This study is supported by the National Science Foundation (NSF) under NSF Award No. NSFNSF-CMMI-0700363. Any opinions, findings, conclusions, or recommendations expressed in this publication are those of the writers and do not necessarily reflect the views of the National Science Foundation.
References
Adkisson, J. (2006). Captive insurance companies: An introduction to captives, closely-held insurances, and risk retention group, iUniverse, Inc.
Andersen, L., and Broadie, M. (2004). “Dual simulation algorithm for pricing multidimensional American options.” Manage. Sci., 50(9), 1222–1234.
Black, F., and Scholes, M. (1973). “The pricing of options and corporate liabilities.” J. Polit. Econ., 81(3), 637–654.
Bier, V. M. (2007). “Choosing what to protect.” J. Risk Anal., 27(3), 607–620.
Boyle, P. (1977). “Options: A Monte Carlo approach.” J. Financ. Econ., 4, 323–339.
Boyle, P., Broadie, M., and Glasserman, P. (1997). “Monte Carlo methods for security pricing.” J. Econ. Dyn. Control, 21(8–9), 1267–1321.
Boyle, P. P., Kolkiewicz, A. W., and Tan, K. S. (2002). “Pricing American derivatives using simulation: A biased low approach.” Monte Carlo and quasi-Monte Carlo methods 2000, Springer-Verlag, Berlin, 181–200.
Breuer, M. (2005). “Multiple losses, ex ante moral hazard, and the implications for umbrella.” J. Risk Insur., 72(4), 525–538.
Brockett, P. L., Cox, S. H., Jr., and Witt, R. C. (1984). “Self-insurance and the probability of financial regret.” J. Risk Insur., 51(4), 720–729.
Brocket, P. L., Cox, S. H., Jr., and Witt, R. C. (1986). “Insurance versus self-insurance: A risk management perspective.” J. Risk Insur., 53, 242–257.
Chance, D., and Brooks, R. (2007). An introduction to derivatives and risk management, Thomson Higher Education, Ohio.
Cheeks, R. J. (2003). “Multistep dispute resolution in design and construction industry.” J. Profl. Issues Eng. Educ. Pract., 129(2), 84–90.
Chiu, W. H. (2000). “On the propensity to self-protect.” J. Risk Insur., 67(4), 555–578.
Del Cano, A., and Pilar de la Cruz, M. (2002). “Integrated methodology for project risk management.” J. Constr. Eng. Manage., 128(6), 473–485.
Doherty, N., and Smetters, K. (2005). “Moral hazard in reinsurance markets.” J. Risk Insur., 72(3), 375–391.
El-adaway, I. (2008). “Construction dispute mitigation through multi-agent based simulation and risk management modeling.” Ph.D. dissertation, Dept. of Civil, Construction, and Environmental Engineering, Iowa State Univ., Ames, Iowa.
El-adaway, I. H., and Ezeldin, A. (2007). “Dispute review boards: Expected application on Egyptian large scale construction projects.” J. Profl. Issues Eng. Educ. Pract., 133(4), 365–372.
Glasserman, P. (2003). Monte Carlo method in financial engineering, Springer, New York.
Gogol, D. (1993). “The value of information in insurance pricing.” J. Risk Insur., 60(1), 119–128.
Grant, D., Vora, G., and Weeks, D. E. (1997). “Path-dependent options: Extending the Monte Carlo simulation approach.” Manage. Sci., 43(11), 1589–1602.
Greene, M. R., and Murray, M. L. (1978). “Self-insurance of state-owned property.” J. Risk Insur., 45(1), 109–120.
Harmon, K. M. J. (2003). “Dispute review boards and construction conflicts: Attitudes and opinions of construction industry members.” Ph.D. dissertation, Nova Southeastern Univ., Fla.
Harrington, S., and Niehaus, G. (2004). Risk management and insurance, McGraw-Hill, New York.
Hart, C. E., Hayes, D. J., and Babcock, B. A. (2006). “Insuring eggs in baskets: Should the government insure against individual risks.” Can. J. Agric. Econ., 54(1), 121–137.
Ho, S. P., and Liu, L. Y. (2003). “How to evaluate and invest in emerging A/E/C technologies under uncertainty.” J. Constr. Eng. Manage., 129(1), 16–24.
Hofflander, A., and Nye, B. (1984). “Self-insurance, captives, and income taxation.” J. Risk Insur., 51(4), 702–709.
Jaffee, D., and Russell, T. (1997). “Catastrophe insurance, capital markets, and uninsurable risks.” J. Risk Insur., 64(2), 205–230.
Janssen, M. C. W., and Karamychev, V. A. (2005). “Dynamic insurance contracts and adverse selection.” J. Risk Insur., 72(1), 45–59.
Jergeas, G. F., and Hartman, F. T. (1994). “Contractors construction-claims avoidance.” J. Constr. Eng. Manage., 120(3), 553–560.
Lee, W., and Ligon, J. A. (2001). “Moral hazard in risk pooling arrangements.” J. Risk Insur., 68(1), 175–390.
Levin, P. (1998). Construction contracts, claims, and disputes, ASCE, Reston, Va.
Ling, L., Tiong, R. L.-K., Fan, W. W., and Chew, D. A.-S. (1999), “Risk management in international construction joint ventures.” J. Constr. Eng. Manage., 125(4), 99–284.
Moore, W. T., and Schmit, J. T. (1989). “The risk retention act of 1986: Effects on insurance firm shareholders' wealth.” J. Risk Insur., 56, 137–145.
Mitropoulos, P., Howell, G. (2001), “Model for understanding, preventing, and resolving project conflicts.” J. Constr. Eng. Manage., 127(3), 223–231.
Mun, J. (2002). Real options analysis: Tools and techniques for valuing strategic investments and decision, Wiley, New York.
Rahman, M. M., and Kumaraswamy, M. M. (2004). “Potential for implementing relational contracting and joint risk management.” J. Manage. Eng., 20(4), 178–189.
Raviv, A. (1979). “The design of an optimal insurance policy.” Am. Econ. Rev., 69(1), 84–96.
Raymar, S. B., and Zwecher, M. J. (1997). “Monte Carlo estimation of American call option on the maximum of several assets.” J. Derivatives, 5, 7–24.
Risk Retention Reporter. (2007). ⟨http://www.rrr.com⟩ (Dec. 1, 2007).
Russell, J., and Zhai, H. (1996). “Predicting contractors failure using stochastic dynamics of economics and financial variables.” J. Constr. Eng. Manage., 122(2), 183–191.
Samuelson, P. (1965). “Rational theory of warrant pricing.” Ind. Manage. Rev., 6(2), 13–39.
Spurin, C. H. (2003). The settlement of manufacturing plant construction disputes, The Nation Wide Academy for Dispute Resolution, London.
Tang, W., Duffield, C. F., and Young, D. M. (2006). “Partnering mechanism in construction: An empirical study on the Chinese construction industry.” J. Constr. Eng. Manage., 132(3), 217–229.
Tsanakas, A., and Desli, E. (2005). “Measurement and pricing of risk in insurance markets.” Risk Anal., 25(6), 1653–1668.
Turnbaugh, L. (2005). “Risk management on large capital projects.” J. Profl. Issues Eng. Educ. Pract., 131, 275–280.
Information & Authors
Information
Published In
Copyright
© 2009 ASCE.
History
Received: Mar 23, 2008
Accepted: Jan 26, 2009
Published online: Aug 14, 2009
Published in print: Sep 2009
Authors
Metrics & Citations
Metrics
Citations
Download citation
If you have the appropriate software installed, you can download article citation data to the citation manager of your choice. Simply select your manager software from the list below and click Download.